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Paul Krugman writes about the current financial reform efforts, and uses a great metaphor for regulatory regimes. Greek armies were specialized and fought better when they had great leaders, while Roman armies were more generic but robust to poor leadership. “And in the end, since mediocre leaders are the norm, the Roman way prevailed.” Heh.

I hate to say this, but the most “Roman” part of the Frank House bill, the clear rule of a 15-to-1 leverage requirement for large systemically risky firms, the part that is exciting to me and to others pushing for strong financial reform, was a fluke. Here’s Ryan Grim, November 20th 2009, Rep. Jackie Speier’s Tough Bank Amendment Passes With Room Nearly Empty:

Don’t sleep on Jackie Speier. The freshman Democrat from California came into the House Financial Services Committee room Thursday ready to fight for her long-shot amendment to limit the leverage ratio for big banks…Lobbyists and committee staffers expected that the amendment…would only get a roll call and that it’d be soundly defeated, bounced by a coalition of Republicans and bank-friendly Democrats, who call themselves ‘New Democrats.’

Instead, there were barely any lawmakers in their seats when her amendment came up during an all-day debate on comprehensive financial regulatory reform. One of the two or three Republicans in the room asked for a roll call, but then quickly reconsidered and withdrew the request.

“I was thrilled,” said Speier, who wouldn’t confess to being surprised that she won. She guessed, instead, that the initial objection was simply Pavlovian.

“There’s a knee-jerk reaction to just oppose everything on the other side,” she told HuffPost. “I think what my Republican friends realized was that after going through this financial nightmare, to somehow argue against putting a leverage cap when we know that what happened was many of these companies — the Bear Sterns, the Merrills, the Lehmans, were all leveraged 30-1 — if we really are going to be real about tamping down that kind of behavior in the future, coming up with a reasonable leverage cap makes sense.”…

“There’s a pattern here,” says Speier. “We put these good laws in place, whether it’s Glass-Steagall or, in that case the SEC cap. But then the industry comes to us and says, ‘Oh, this is cramping our style. We could make’ — of course they don’t say it this way — ‘we could make so much more money if you just lifted this cap.’ And they were right. They made a lot of money and they also brought the entire country to its knees.”

Go Jackie Speier. But note that this snuck by in the House, and if it isn’t in the Dodd Bill, it is very likely to just be dropped in conference committee. Nobody seems all that excited among the administration, lobbyists or Congress to put an actual hard rule the financial sector will have to play by into the final bill. Why is that?

The Permanent Committee to Save the World Forever Bill

Krugman wrote: “I’m all for passing reform. But I’m not that optimistic that it will work, even if it passes.” And in general I get a “is this it?” when people see the reform bill in play. Why aren’t they pushing for more structural changes to the financial sector? Why not some hard caps on size of liabilities, like the Volcker Rule (which wasn’t even mentioned by Geithner at his recent AEI speech).

What story of financial reform is told with this bill? It isn’t a story where the financial sector isn’t too far out of control, too top-heavy and concentrated and opaque and gigantic. And it isn’t a story of regulatory failure, where regulators were asleep at the wheel, corrupted and captured through assumptions of how the world works and a revolving door of influence with the biggest firms, or where they were simply outmatched in knowing what they needed to do.

It’s a story where the regulators just needed a bit more power, a little more legal scope, and a greater extension of what jurisdiction the Federal Reserve has in order to rush in and save the day. A story where the Federal Reserve can successfully carry out prompt corrective action, detecting problems early and guiding banks back to health, on an institution with $2 trillion dollars on its sheet. A story where that institution’s off-balance sheet and the warehouse of derivatives it holds are no match for our regulator’s stare. But more importantly, it is a story where the regulators will be able to sweep in during a moment of crisis and keep the financial sector working no matter what.

I don’t like the idea of the Saving the World Forever approach to financial reform for three reasons:

  1. I don’t think it’ll work. The biggest banks are all bigger now, and I worry they may even be emboldened in the medium term once the economy starts to pick up again. The Lehman bankruptcy report by Jenner shows that the Federal Reserve, after they were called in by the SEC after the SEC was in over its head, were not stellar when it comes to get accurate valuations of the books (a review by Frank Partnoy here).
  2. We are in a lot of trouble if this goes bad and we have another financial crisis in 6-8 years.
  3. There are alternatives (also my recommendations and comments on the Dodd Bill here) that involve stricter rules, better regulation of derivatives, smarter resolution authority, etc. These would supplement the ability of regulators to be smart and use their discretion well. Some of this is very low-hanging fruit in terms of changing the bills currently in play.
Source: Why I Don't Like the 'Saving the World Forever' Approach to Financial Reform